O'Connor: How to prepare for stock market swings

Crises that buffet the financial markets have become commonplace in recent years: 2008’s banking crisis, the housing market implosion, credit woes at home and abroad, currency fluctuations, natural disasters. As a result, stock prices have been extremely volatile, sometimes rising or falling by 10 percent or more in a matter of weeks – or even days. The past couple of years have been challenging for investors, to say the least.

Fortunately, there’s a straightforward way to meet the challenge of market volatility. The key is to create a mix of investments that can weather big swings in the stock market — while still providing the potential for gains over time.

While the recent frequency of market disruptions may seem unprecedented, investors can take a lesson from prior decades’ periods of extreme stock market swings, including severe declines. In the mid-1970s, a deep economic recession and a national energy crisis contributed to steep drops for stocks, which fell more than 26 percent in 1974 alone. And the early 2000s’ collapse of the dot-com bubble led to a string of annual losses, with stocks dropping more than 22 percent during 2002.

These periods clearly demonstrated the dangers of volatile markets, which can generate sudden and steep drops as well as prolonged slumps. Investors learned not to take more risk than they were comfortable with.

Unfortunately, many investors had forgotten that lesson by 2008. That year, some investors nearing retirement were caught with stock-heavy portfolios when the downturn hit. They saw their nest eggs shrink dramatically as the stock market plummeted, jeopardizing their retirement plans.

Worse, some of those investors compounded their mistake by moving money out of the declining stock market in hopes of minimizing their losses. By the time stocks finally bottomed out in March 2009, investors had withdrawn nearly $25 billion from equity funds. As a result, they weren’t positioned to participate in the dramatic market rebound that began that month and led stocks to a gain of almost 27 percent for the year.

Those mistakes offer an important reminder of how not to react to short-term market swings. Though double-digit drops in the S&P 500 can be scary, they shouldn’t trigger big changes in your investment strategy. Radical changes based on emotion probably aren’t the best decisions in hindsight.

Instead, you should build an all-weather portfolio: one designed to perform reasonably well in up markets without exposing you to risk beyond your tolerance when stocks hit a rough patch.

Start by reviewing your asset allocation — how your portfolio is divided among different types of investments. A good asset allocation strategy establishes the right balance of stocks, bonds and cash holdings. The more stocks you hold, the more vulnerable your portfolio is to short-term drops in the stock market. But avoiding stocks – which offer strong return potential – may make it difficult to reach your long-term financial goals. Investors need to recognize the trade-off between risk and return. If you want to earn better than zero percent returns, you need to take some risk.

Of course, just how much risk you can tolerate will factor into your selection of investments. Based on your circumstances, your financial adviser can help you determine which investments suit your goals for capital preservation and long-term wealth building. For instance, a young investor who has decades before retirement won’t need to draw on his or her retirement savings for decades and is more likely to tolerate even significant market fluctuations. Such an investor can probably afford to hold a larger stake in stocks than an investor who is just a few years from retirement.

There’s no way to predict when a market downturn will hit. That’s why it’s important to review and adjust your asset allocation strategy now – before the next big surprise comes along. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.

• Patrick S. O’Connor, CRPC is the Managing Principal, Senior Financial Advisor and a Chartered Retirement Planning Counselor CRPC at Wells Fargo Advisors Financial Network off of Randall Road next to the new Hobby Lobby in Algonquin. He can be reached at 847-458-0142, emailed at p.oconnor@wfafinet.com or at www.algonquin.wfadv.com.